Over the past year, the notion that certain large financial institutions are “too big to fail” has become the conventional wisdom on Wall Street and in Washington.  Starting with the Bear Stearns rescue over a year ago, the Federal Government has taken various measures to deal with systemic risks to the financial system.  Many of these initiatives are now very unpopular and are seen as providing aid to companies and individuals who “rolled the dice” and should have to suffer the economic consequence of their bad decisions.

At a time when most government officials in the executive branch and at the Federal Reserve continue to support the “bail out” approach, Thomas M. Hoenig, President of the Kansas City Federal Reserve bank and a voting member of the Federal Open Market Committee, has put forward an alternative prescription to deal with the troubled financial system.  The text of Mr. Hoenig’s recent testimony before the Joint Economic Committee of the United States Congress requires close attention.

Success Depends on Failure

The central argument that Hoenig makes in his Congressional testimony as well as in the text of a speech given earlier this month at the Tulsa Chamber of Commerce is that failure must be an option even for systemically important financial institutions.  If failure is not an option for large firms and the shareholders, creditors, and management of financial institutions realize this, all kinds of perverse incentives will exist to take on unwise risks knowing that negative consequences will be mitigated.  Incentives will exist for marginal firms to attempt to expand to the point where they are in fact “too big to fail”:

… If any bank is examined and found to be insolvent, it needs to go through the resolution process with the owners losing their investment. However, the eventual outcomes for the institution can be different. A smaller bank’s assets and deposits will likely be sold to another bank. In the case of a larger bank, the firm might be temporarily operated as a bridge bank before either being sold or reprivatized. Regardless, it is important that the banks go through the same process or else an incentive will be created for banks to take on excessive risks in an effort to grow large enough to gain favorable treatment.

The key point that Hoenig makes throughout the text of his speech is that financial institutions, both small and large, need to be subjected to the same tests of solvency and that there must be a consistent definition of what it means for the bank to have “failed”.  Hoenig acknowledges that the resolution for large systemically important institutions might well be different from the resolution used to deal with smaller failures.  However, the principle that shareholders should be wiped out and the management and board of directors replaced should apply to failed institutions regardless of size.  Hoenig goes into some detail regarding the methods that could be used to resolve larger institutions citing the example of Continental Illinois in the 1980s and the Swedish response to a banking crisis in the early 1990s.

Bailouts Doomed to Fail

It is important to avoid creating moral hazard when resolving a failed institution.  If management is allowed to continue running the company and shareholders are insulated from the consequences of the failure, Hoenig believes that there is no reason to expect different outcomes in the future.  While acknowledging the pressures facing public officials at the outset of the crisis, he is very critical of the steps that have been taken over the past year and the failure to create a more consistent plan of action:

When the crisis began to unfold last year, and its full depth was not yet clear, we were quick to pump substantial liquidity into the system. In the world we find today, with the crisis continuing and hundreds of thousands of Americans losing their jobs every month, it remains tempting to pour additional funds into these institutions in hopes of a turnaround. We have taken these steps instead of defining a consistent plan or addressing the core issue of how to deal with these institutions that now block our path to recovery. Our actions so far risk prolonging the crisis while increasing the cost and raising serious questions about how we eventually unwind these programs without creating another financial crisis as bad or worse than the one we currently face.

When Hoenig states that another crisis as bad or worse than the current one could result from programs such as TARP, this is primarily due to the incentives the programs are creating for managements and for shareholders of the bailed out institutions.  It is naive to think that individuals will believe that the current policy is “one time only” and that future bail outs will not occur.  In fact, they will most likely believe exactly the opposite.  Hoenig notes that 46 smaller banks have failed in the United States since the beginning of 2008 and have been resolved through the process he recommends.

Principles for a Resolution Framework

In attachments to his Congressional testimony, Hoenig presents details of the proposed resolution framework.  In the section related to the principles of the resolution framework, he stresses the need for a free market system that requires business owners to capture the profits from successes and bear the cost of failure.  He also notes the need to have a transparent set of rules for addressing how a failed institutions will be resolved so that all market participants know in advance the steps that will be taken if necessary.

Two main principles for the resolution process should be to minimize the costs to the overall economy and to be equitable in the treatment of all financial firms regardless of size or location.  He goes into more detail regarding the specific prescription for a resolution process to be used with larger firms.  Much of this is modeled after the Continental Illinois and Swedish banking cases mentioned previously.

At a time when everyone is waiting to review the details of the government’s stress test methodology and public outrage over bailouts continues to grow, it is more important than ever to step back and consider whether the premise behind the current policy holds up to scrutiny.  As I wrote recently, shareholders of Wells Fargo and other banks will be waiting to see if regulators demand measures that will dilute current shareholders.  Hopefully the issues raised by Thomas Hoenig are being actively considered at the Treasury and Federal Reserve as the stress testing criteria are finalized.